Remember, everybody’s wrong.
Today, we’ll focus on how everybody’s wrong about valuations.
I’m almost finished reading my friend Barry Ritholtz’ new book, “How Not To Invest.”
Barry is the co-founder of the fastest-growing investment advisory firm in the country. He and my friend Josh Brown, CEO of Rithotlz Wealth Management, now manage more than $5 billion in client assets.
Barry’s first book, “Bailout Nation,” is a must-read for anyone interested in learning more about what went down during the Global Financial Crisis/Great Recession.
I can’t believe that book came out 16 years ago.
In his latest, he poses the question, how much should “fair value” matter to investors?
In other words, how cheap or expensive are stocks today, based on the relationship between their prices and their earnings?
Barry proves that, in reality, this is a trick question. Most of the time, it’s not especially relevant.
The Chapter on Valuation
A 2018 New Year’s Day article in The Wall Street Journal frames a perfect example: “What to buy when nothing is cheap?” was the issue.
Valuations were high, and stocks were too expensive to buy, according to the WSJ.
Journalists implied valuation is the singular factor investors should rely on to make buy and sell decisions about stocks.
Since January 2018, the S&P 500 has more than doubled, and the Nasdaq100 has more than tripled.
What’s hilarious is that cheaper stocks significantly underperformed.
The relatively cheap stocks in the Russell 2000 Small-Cap Index have returned only 25% since January 2018.
And the even-cheaper MSCI All Country World Index Ex-US is barely up at all since January 2018.
Of course, as Barry writes, “Valuation cycles are driven primarily by psychology.”
And it’s important to understand how the cycle unfolds: “Starting out with investor indifference and ending with investor overenthusiasm.”
The bottom line is, “Cheap stocks are not always good buys, and pricey stocks don’t always disappoint.”
Ultimately, Barry demonstrates with a lot of data that “valuation matters less than we tend to believe.”
And – of course – “even when it does matter, we tend to make the wrong decisions.”
It is true that “rising earnings are good for stock prices.”
But there’s something more important: rising multiples.
“The major determinant of stock price returns isn’t growth in corporate profits,” Barry writes, “but rather changes in price / earnings multiples.”
As Barry concludes, “The conventional analysis is wrong.”
And he breaks down earnings growth by decade since the middle of the 20th century to prove it.
The 1950s, for example, saw earnings per share (EPS) growth of 3.9% per year. But the index of stocks rose 13.6% per year.
During the 1960s, EPS rose 5.5%, but stocks rallied only 5% per year.
In the ’70s, EPS skyrocketed to 9.9%, but stocks barely gained 1.6%.
During the 1980s, EPS rose 4.4% but gains were over 12%.
In the ’90s, you saw 7.7% EPS growth while stocks returned 15% annually.
During the 2000s, you saw 4% EPS gains per year but a NEGATIVE 3.8% return in the indexes. Stocks actually fell that decade.
As Barry concludes, “There is very little correlation between earnings growth and share price appreciation.”
Make sure you check out “How Not to Invest.” And, if you haven’t read it already, take a look at “Bailout Nation” too.
Stick With the “P”
Meanwhile, here’s the Nasdaq100 closing at its highest levels ever Tuesday:
People are worrying about valuation.
They focus too much on the denominator of the price-to-earnings (P/E) ratio.
It’s the “E that they’re obsessed about when it’s only the “P” that actually pays us.
Everybody’s wrong.
Ignore the E.
Stick with the P.
Stay sharp,
JC Parets
Founder, TrendLabs